Breaking down protective puts, pairs trades, collars, and the stock repair strategy
The stock market has been volatile over the past few weeks, notching record highs before pivoting lower following a Big Tech slump, then higher again after the Federal Reserve noted interest rate cuts could be coming later this year.
Treaders have plenty of reasons to be on edge amid this volatile market environment, but they should not forget there are several ways to protect their portfolios from these swings, including protective puts, pairs trades, collars, and the stock repair strategy.
Protective Put
A put option is bought when a speculator has a bearish view on the market, but wants more limited risk than a short seller. By purchasing a put, the trader has the right to sell 100 shares of the stock at the strike price, should the security fall below the strike by expiration. In other words, puts profit with each step below the selected strike the underlying takes over the life span of the option.
As a hedging vehicle, shareholders can employ protective, or "married," puts to guard against losses to their portfolios. For instance, if a trader is optimistic about a stock in his or her portfolio, but the market environment is volatile and/or the company's earnings report is looming, he or she can buy to open an out-of-the-money (OOTM) put.
This gives the trader the right to sell the stock at a comfortable level in the event of a drop -- and possibly make a profit off the sale of the long put. Conversely, should the stock continue its ascent, the trader can surrender the initial premium paid to buy the put, and watch the portfolio grow.
Pairs Trades
A pairs trade is a two-pronged strategy used by a speculator with a more neutral outlook. In other words, this trader may be bullish on a certain equity, but nervous about the overriding sector or broader market. To implement the pairs trade, he or she may buy a call on the security he's optimistic about, and simultaneously buy a put on that equity's sector.
This allows investors to cover their bases, and profit from a move in either direction. In the best-case scenario, the stock will rise, while the broader sector lags, and the trader can collect gains on both the call and the put.
Collars
Similar to a protective put, a collar is a strategy used by a shareholder to limit downside risk. A collar, however, lowers the cost of playing a protective put by combining it with a covered call. By saving a little cash on the cost of entry, though, the speculator raises risk. Specifically, should the security rally above the strike of the short call, the shares may be called away. This means traders must choose a strike price at which they are comfortable unloading shares.
Stock Repair Strategy
The stock repair strategy is useful when a security suffers substantial losses. In order to try and recover from the loss at no cost, the trader would implement a call ratio spread by buying to open enough at-the-money calls to cover the number of shares in his or her portfolio, while simultaneously selling to open two out-of-the-money calls for each one bought.
The cost of the long calls will ultimately be offset with the credit collected by the short calls. While the stock repair strategy does not protect the shareholder from additional losses in the equity, it can lower his breakeven point.